When the first cryptocurrencies were created, their underlying goal was to solve certain problems that plagued traditional fiat currencies and banking systems. A major problem was the cumbersome cross-border payment systems. There were also a significant number of unbanked and underbanked individuals. Other challenges include multiple intermediation charges by third-party platforms per wire transaction, high remittance fees, and identity fraud.
Why are Privacy Coins Important?
Millions of retail investors and corporates shifted their interest to cryptocurrency markets. Hence, an increasing need by several market players for privacy arose as they executed cryptocurrency transactions. On one hand, blockchain ensured that transactions executed using traditional cryptocurrencies like Ethereum were secure and well recorded. Nonetheless, law enforcement and other market players could determine the identity of transaction participants using the transaction logs.
In reality, the advantage of ‘anonymity’ claimed to be provided by a traditional cryptocurrency like bitcoin is a myth. This is because bitcoin’s blockchain is public. This further implies that all transactions ever made by any bitcoin address can be viewed by anyone, any time, on any public blockchain explorer.
Thus, a new series of blockchains were created to enhance privacy. As such, only participants in a transaction would know the amount transacted and the parties involved. External participants would be completely walled out. These new privacy-enhanced blockchains are powered by cryptocurrencies which are now generally described as ‘privacy coins’.
According to Coindesk, a privacy coin is a cryptocurrency that preserves anonymity by obscuring the flow of money across its network. Essentially, it goes the extra mile by making it difficult to determine who sent what to whom, which is true anonymity. Today privacy coins account for 0.65% of the total cryptocurrency market, with an overall market cap of USD11.96 billion.
Top Two Privacy Coins Today
Two privacy coins lead the curve in the crypto market today:
The world’s largest privacy coin by market cap, Monero, is private by default. To anonymize each transaction, Monero uses one-time public keys. This key is otherwise known as stealth addresses. They are used to hide the accounts participating in the transaction from outside viewers on the blockchain. It further hides the sender’s identity using ring signatures which group real transactions with decoys. Lastly, since 2017, Monero’s RingCT tool has been used to hide transaction amounts.
ZCash is the second-largest privacy coin in the world by market cap. It offers both transparent (t-address) and private transaction (z-address) modes. In the private mode, z-addresses are used to obscure the identity of the sender. Z-addresses work using zero-knowledge proof algorithms through which transaction participants can prove possession of their digital assets without divulging any information. Thus, in a transaction between two z-addresses, one can only verify the time that a transaction occurred on the blockchain, but it is impossible to know who participated or how much was transacted.
Challenges with Privacy Coins
Benefits considered privacy coins aren’t without their pitfalls. Cryptocurrencies have been linked to terrorist financing in the Middle East and North Africa. Given their nature of prioritizing anonymity and privacy above all else, privacy coins are a key suspect. They are also viewed as an outlet for money laundering and dark web commerce. As a result, there has been a wave of strict regulatory clampdowns on privacy coins. South Korea and Australia have banned exchanges operating in their jurisdiction from listing privacy coins, while Japan has banned them in their entirety.
Additionally, mixers/tumblers exist as a viable alternative to privacy coins. For example, when a cryptocurrency such as Dogecoin is sent through a mixer, the mixing service jumbles it with the Dogecoin of other people using the mixer at the same time. Subsequently, the service spits out an accurate amount of random Dogecoins to the intended recipients, making the initial sender untraceable. Coinomize and Chipmixer are two of the most popular mixers.
Hence, in the future there is an expectation that increased competition to privacy coins will arise.